United States: Private Equity Viewpoint: Protecting Your Investment
Insurance for portfolio companies’ M&A transactions

With the recent uptick in merger and acquisition (M&A) activity, a number of private equity firms have begun to consider a relatively new form of insurance coverage to help facilitate their portfolio companies’ transactions. This coverage — M&A insurance — has become increasingly popular, and this article provides an overview of situations in which M&A insurance should be considered and how such insurance works.

Private equity investors and their portfolio companies should consider M&A insurance in several situations: (1) "capping" indemnification exposure when on the "sell side;" (2) providing additional protection for representations made by the seller when on the "buy side;" and (3) dealing with specific liability concerns.

Sell-Side Coverage. In the context of a sale, most private equity firms desire to distribute as much of the transaction proceeds to their limited partners as soon as possible. This desire, however, must be weighed against the risk that the buyer of the portfolio company may, under certain circumstances, have recourse against the selling stockholders (such as a private equity fund) for liabilities even beyond any escrow if a breach of the transaction representations and warranties occurs. In order to reduce this risk and to facilitate timely distributions, so-called "reps and warranties" insurance may be obtained to protect the selling stockholders from losses arising from unknown or undisclosed liabilities resulting from a breach of any of the representations or warranties contained in the transaction documents. Further, the insurance typically will pay for the costs associated with the defense of any litigation relating to an alleged breach. The coverage can be particularly useful to facilitate the sale of a portfolio company when a buyer is insisting upon a significant escrow or a high (or even unlimited) cap on liabilities that otherwise will lock up too great a share of the transaction proceeds.

Buy-Side Coverage. Now consider the M&A transaction from the other side — that is, when a portfolio company is making a substantial acquisition of another company. There may be situations where the buyer regards the amount of any escrow or the rights to indemnification from the selling stockholders as relatively weak protection if a significant liability were to arise from a breach of the seller’s representations and warranties. Practically speaking, a disparate group of selling stockholders also may be difficult to collect from should a sizeable claim occur. The possibility of an actual misrepresentation or fraud by the seller also looms as a potential transaction risk. "Buyer’s side" reps and warranties insurance is designed to address these concerns. It allows the buyer to make a claim directly to the insurance carrier when liabilities resulting from a breach of any representation or warranty exceed the amount of the policy deductible (which often is tied to the amount of the escrow or any indemnification payment – so as to prevent "double dipping" by the buyer). It thus covers the buyer for losses above the escrow or contractual indemnification, relieves the buyer’s concerns about the seller’s creditworthiness, and even protects the buyer against deliberate misrepresentations by the seller. The parties to a prospective deal may decide to share the cost of the insurance as a means to facilitate the deal getting done and removing deadlocks over issues such as the size of the escrow, the cap (if any) on indemnification liabilities, or the duration of the seller’s indemnification obligations.

Special Liability Issues. There may be situations when a specific liability concern is blocking the transaction from getting done. Insurance carriers now are offering a variety of coverages targeted at these situations to facilitate completion of the deal. The most common forms currently available in the market provide tax liability and opinion coverage, environmental liability coverage or litigation buy-out coverage.

• Tax liabilities. Tax liability and opinion coverage is designed for transactions where favorable tax treatment is a deciding factor as to whether the transaction will occur. The coverage is particularly appropriate when the parties to such a prospective transaction cannot agree on their respective shares of post-transaction tax liability risk or when the parties simply want to reduce this kind of liability exposure. If the U.S. Internal Revenue Service or any state or foreign tax authority challenges the tax treatment of the transaction, then the insurance typically will provide coverage for the additional taxes owed, interest, any non-criminal penalties and attorney’s fees incurred to contest and resolve the unfavorable tax treatment. Insurance carriers have shown a willingness to consider coverage for a wide variety of potential tax liabilities, even novel "one-off" tax situations where the insurance policy form has to be created from scratch to address the specifics of the deal.
• Environmental liabilities. Similar to tax liability concerns, environmental liability issues often can get in the way of completing a deal. Insurance carriers offer environmental liability coverages to address these situations or simply to mitigate environmental liability exposure. The insurance typically takes one of two forms. First, coverage is available for known remediation situations where final clean-up costs have not yet been determined or remediation cost over-runs may occur. Second, coverage is available for unknown pollution liabilities, regardless of whether pre-existing contaminants are known or unknown. The coverages may be particularly useful for M&A transactions where the buyer and seller cannot agree on the level of the seller’s indemnification obligations for environmental liabilities, or when the seller’s ability to fulfill those obligations may be in question.
• Litigation. Litigation buy-out coverage is perhaps the most straightforward of the M&A coverages. In essence, insurance carriers who offer this kind of coverage are agreeing to take on (typically for a substantial price) the liability and defense costs for an uninsured or under-insured lawsuit or pre-litigation situation. This kind of coverage may be particularly attractive for a portfolio company looking to be sold or attempting to raise additional equity but which finds that a lawsuit or threat of litigation has scared off potential suitors or investors, or has severely impacted the company’s valuation. In these situations, the cost of the insurance may well be offset by the financial benefit derived from removing the buyer’s or investor’s rationale for the discounted valuation. The insurance can be structured in a number of ways to address the company’s level of potential liability and the cost of the insurance, ranging from full coverage for whatever costs the lawsuit brings to a simple cap on liability once the costs reach a specified point.

How Does It Work? Typically, there is no cost to have an experienced insurance brokerage explore whether one of these kinds of M&A coverage is an appropriate option for a given transaction. However, in order to move forward to obtain a policy, the insurance carrier will need to perform its own due diligence on the transaction and the risks subject to coverage. Often the carrier will require access to all materials relevant to the deal, and this outside diligence process may give rise to issues relating to disclosure of privileged documents. Moreover, the carrier will request a retainer from the prospective insured in order to cover the costs of this due diligence. Finally, the actual terms, conditions and limitations of any policy that is ultimately written will have to be examined and negotiated carefully.

Conclusion – think outside the box. Insurance carriers obviously are trying to capitalize on the risks of liability arising from M&A transactions by selling insurance coverages targeted at those risks. In developing this market, carriers currently are willing to be flexible and to apply a variety of coverage solutions (or even to craft new ones) addressing the often specific or unique liabilities posed by a particular transaction. Some of these coverage options have been especially attractive to private equity firms and their portfolio companies, which may find that the financial gains associated with removing or minimizing the risk of certain liabilities far outweigh the cost of the insurance. It makes sense to be familiar with and to evaluate using this risk management strategy, particularly in situations where the parties to a transaction appear deadlocked over one of the types of liability exposures discussed above.